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In the current uncertain and volatile market environment, I believe that a portfolio with high quality, short-term fixed income securities at its core can deliver attractive, inflation-adjusted returns over the long haul. This core would consist primarily of highly-rated (i.e. investment grade) U.S. corporate bonds, Treasury notes, bank certificates of deposit and similar securities.
This portfolio would seek to employ primarily a buy-and-hold strategy; virtually all of the securities would be purchased and held until maturity. To minimize interest rate risk, the average maturity of the bonds in the portfolio ought to be limited to no more than five years and preferably around three years.
The targeted long-term return on the portfolio would be 100-200 basis points over the rate of inflation. With inflation running around 5% currently, the goal under current market conditions would be to achieve a total return of 6%-7%. Today, this translates into an average yield spread of 420-520 basis points over Treasuries. With the current high spreads available in most fixed income sectors, this is an achievable goal. In fact, with inflation expected to ease and the likelihood that bond yields will decline as the financial crisis passes, there is good potential for achieving price appreciation and high total returns on fixed income investments in the months ahead.
These total return parameters are available in many fixed income sectors; but there is ample opportunity to achieve the targeted returns with a focus on U.S. corporate bonds rated double-A to BBB. This, I believe, is a good sandlot in which to play. This lower range of the investment grade sector offers high historic yield spreads at what should be acceptable levels of risk. From time-to-time, we should also be able to find other securities, such as TIPS or bank CDs, for example, which meet our target return parameters for our core portfolio.
We can also look at certain sectors outside of the core that have the potential to deliver higher tax- and inflation-adjusted returns. These might include high yield corporate bonds, REITs, closed end bond funds, municipal bonds, preferred stocks and even certain high yielding equities, such as master limited partnerships. Obviously, many of these investments carry higher risk levels, as well. However, we should limit them to no more than say, 30% of the portfolio.
It is important to note that over time the composition of the entire portfolio, including the core, may shift somewhat along with market conditions. For example, if yield spreads rise sharply - well above the rate of inflation - due to growing concerns about a more severe slowdown in the economy, we might seek to shift the portfolio’s exposure toward higher rated bonds, say those rated AA and above, because they can meet help us to meet our target return objectives with less risk. At the same time, we might conclude that the selling in certain securities, say in the junk bond sector, for example, has been overdone at least with respect to a few companies whose businesses and financial positions ought to remain solid, even in a tougher economic environment. In these cases, we might reach a little bit into riskier, lower quality sectors of the bond market to augment our returns.
In this way, we should be responsive to current market opportunities and risks, recognizing, however, that any portfolio changes that we make will most likely be gradual, because we have committed most of our funds to investments that we intend to hold to maturity. Only in extreme circumstances - in response to say a significant deterioration in the prospects for a company whose bonds we hold - should we consider selling any security before it matures.
I believe that this strategy offers a better risk/reward profile over the next 5-10 years than a traditional investment portfolio that relies on a heavy weighting in common stocks. After enjoying an incredibly long run with above average returns for more than a quarter century, the U.S. stock market has suffered a major setback in 2008. Even though the stock market may recover, many of the problems that we have seen recently could take this country several years to resolve and the stock market could remain quite volatile during this workout process.
If I am correct in my assessment, then investors who pursue an investment strategy focused primarily on high quality, short maturity bonds should experience less overall stress. In baseball terms, the goal here is to focus on hitting singles and an occasional double, not swing for the fences. Consequently, we should end up striking out less often.
That does not mean necessarily that we will be able to avoid losses completely. I believe that this strategy, while clearly more boring than the pursuit of hot stocks, is not without its pitfalls. In this sector, the highest annualized rate of return that you should expect on a single investment is maybe 15%. In stocks, having some big winners helps to offset some of your losers. With a bond-focused strategy, losers can quickly erode your returns. Under the approach that I have described here, you should be able to sleep better at night, but you will almost certainly have to work just as hard, if not harder, during the day.
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Originally published February 28, 2008. Updated to reflect current market conditions on October 26, 2008.
Stephen P. Percoco
Income Builder
P.O. Box 1409
Mashpee, MA 02649
(732) 763-0763
incomebuilder@larkresearch.com
© 2008 Lark Research, Inc. All Rights Reserved. Information is carefully compiled but not guaranteed to be free from error. Specific reference to any specific security should never be construed as a solicitation to either buy or sell. Reproduction without permission from the publisher is prohibited.